How Accumulated Benefit Obligation Works

During retirement, the pension plan expects to pay employees an amount in its present value. This is called accumulated benefit obligation. The present value depends on current salary levels and accumulated work service during the time of measuring pension liability.

The accumulated benefit obligation's estimation is done when there is an assumption that the pension plan will undergo immediate termination. As a result, it doesn't require an increase in salary in the future. There is a slight difference between accumulated benefit obligation and projected benefit obligation.

When it's assumed that a pension plan will be ongoing, there is an increase in future salary. Financial Accounting Standards Board (FASB) requires business companies to file statement number 87. These FASB statements are necessary as they disclose and quantify personal liabilities and the companies' pension plans' performance and financial position. It requires three methods to measure this:

  • Vested benefit obligation (VBO)
  • Projected benefit obligation (PBO)
  • Accumulated benefit obligation (ABO)

Example of an Accumulated Benefit Obligation

Let's say that Cypress Company's financial statement for the 2017 fiscal year details both PBO plans asset and ABO amounts. The company had $25 billion as an accumulated benefit obligation for their domestic pension plans. This means that the Cyton Company had a liability to pay the employees $25 billion as the pension amount. $20.3 billion was the pension plan's current value.

The liability amount was $25 billion and was greater than the $20.3 billion, which is the plan's asset. Simply put, there was an underfunding of $4.7 billion in the plan. On the company's balance sheet, the recording of this amount was made as part of long-term benefits and liabilities for the individual.

Types of Accumulated Benefit Obligation Changes

Since PBO assumes an increase in salary over time, many financial analysts consider this the most accurate pension measure for a company. The assumption of an increase in salary over time results in an increase in liabilities that requires pay-out preparation. The annual ABO might change due to several factors including the following:

  • Foreign exchange losses and gains
  • Interest costs
  • Contribution by plan participants
  • Service costs
  • Actuarial losses and gains

The assets plan can either be overfunded or underfunded when comparing it to the ABO. An underfunded pension plan is when the assets of a plan are lower than the ABO. Overfunding of the pension plan occurs when the plan's assets exceed the ABO. On the company's balance sheet, the booking of underfunded plans is made as a long-term liability.

At the end of the day, two main factors determine whether a plan is overfunded or underfunded. They include the rate of return that is long-term and the discount rate. There will be an equal or increased underfunded estimated account if a decline happens in the discount rate. However, the overfunded amount will fall if the plan assets' return rate increases, making all the other variables constant.